Small Towns, Big LossesStephanie Anderson Forest and Zachary Schiller
To folks in Portage, a rural Ohio county east of Akron, Maurice H. "Mo" Kline is a pillar of the community. In his 32 years as county treasurer, Mo has come to know the area and its people pretty well. So, when the septuagenarian retired last August, he was feted with three celebrations--a perfect finale to a long and successful career. A highlight was a surprise dinner hosted by his friend and investment adviser, James W. Winter, a senior vice-president at Government Securities Corp. of Texas. Problem is, Mo wasn't in much of a mood to celebrate.
No one could blame him. A few months before retiring, Kline, 72, discovered that he had made the biggest mistake of his career: At Winter's suggestion, Kline had invested in highly speculative, interest-only, mortgage-backed securities, or IOs, a market that has lost more than 50% of its value this year. In May, Kline took a $1.7 million loss on the $4.2 million IO investment. And when he left office on Aug. 31, Portage County was still stuck with a batch of IOs that could boost the losses by an additional $3.3 million. Together, the potential losses could add up to nearly 10% of Portage County's $56 million investment portfolio. Kline says the fiscal blunder represents "a devastating period in my time [as treasurer]....I'm just a common, ordinary treasurer who had a misunderstanding, a misconception of what was offered."
"PEOPLE MAKE MISTAKES." Kline isn't alone. More than a dozen local governments in Ohio face losses from IO investments. Holders of IOs forgo principal payments from pools of mortgages but at one time could receive big interest payments. Thanks to yields over Treasuries of as much as four to five percentage points, IOs gained popularity in recent years as investors reached for high returns in the face of falling interest rates. But widespread mortgage refinancing has slashed IO interest payments, causing a big drop in IO prices. Although the Ohio losses--as much as $13 million so far--seem modest, they're having an impact on some small communities, which may be forced into such steps as cutting police services.
The episode is a dramatic example of what can occur when unsophisticated investors buy complex securities peddled by relatively unknown brokerage houses operating on the fringes of the securities industry. Many of the IOs were sold by Government Securities Corp. GSC and several of its current and former officers have a history of questionable activities and run-ins with regulators (table). Ohio securities regulators are investigating GSC and two other firms that have sold IOs. "Many firms that do business in riskier securities will gravitate toward smaller jurisdictions because of the naivet of their investment managers. For them, investing is only a small part of their jobs. IOs are such that if you don't track them full-time, you'll get stung," says Rod Rich, chairman of the investment policy committee of the Municipal Treasurers' Association of the U.S. & Canada. Portage and Sandusky Counties sued GSC to recover their losses, and more local governments may do so.
GSC Chairman Christopher L. LaPorte dismisses such actions: "They are under pressure, and they need a scapegoat. We are the scapegoats." He also downplays the questionable backgrounds of some of GSC's principals: "People make mistakes, but that doesn't mean they're bad forever."
So far, Ohio is the only state where widespread public-fund IO losses have surfaced. But the damages could climb in Ohio and elsewhere as auditors conduct routine examinations of other counties, cities, villages, and school districts that may have done business with GSC and other firms. GSC and securities firms such as Houston-based Hart Securities Inc. are believed to have peddled IOs in Kentucky and Florida, among other states.
LEGAL BATTLES. Officials at most of the Ohio government entities--most of them in rural areas--where losses have been discovered claim they were duped into buying the securities by aggressive salesmen who failed to disclose the inherent risks of IOs. "I was totally misled. Based on everything I was told, I believed these [IOs] were risk-free. I wouldn't have invested in them otherwise," says Rosalie Townsend, treasurer of the 2,700-student Vermilion (Ohio) school district. Townsend, who manages a $2.5 million investment portfolio, suffered a net loss of $127,000 on a $198,000 IO bond purchased in October, 1991, from former Hart broker Kenneth J. Schulte, who now works for Comprehensive Capital Corp. in Boca Raton, Fla. Schulte declined to comment. Both Hart and GSC, which claim IO volume among nationwide customers at $10 million and $50 million, respectively, insist they informed customers of the potential perils of IOs.
Still, GSC is seeking to settle a lawsuit filed last month by Sandusky County--whose losses the state auditor says could be as high as $2.5 million--and County Treasurer Virgil Swartzlander charging GSC and Winter with federal and state securities fraud. It alleges that Winter told Swartzlander IOs were government-backed or government-issued. GSC has also sued Sandusky County commissioners, alleging that the county officials who signed off on the purchases were experienced investors.
Although such difficulties are not new to GSC, Ohio's fiscal officers are apparently just learning the background of GSC and some of its former and present principals. Established primarily to trade small-business loans 14 years ago, GSC has blossomed into a diversified 130-employee securities brokerage with gross profits of $39 million in the last fiscal year. Company founders LaPorte, John Mark Lee Osborne, and Rick E. Pierson all hail from Hibbard, O'Connor & Weeks Inc., a now-defunct Houston securities firm. Hibbard was the target of several regulatory actions. In 1976, for instance, the Securities & Exchange Commission imposed sanctions on the firm and two of its principals, then-President Osborne and Chairman Aubrey D. O'Connor, for such fraud violations as concealing the true financial condition of a subsidiary. LaPorte and Pierson weren't implicated. Neither the firm nor its principals acknowledged wrongdoing.
MALL MURDER. GSC has had several brushes with securities laws. In 1985, the company was suspended by the Texas Securities Board for five days for selling securities without registering as a dealer. Public records don't show whether GSC admitted or denied liability. In other situations, GSC and its principals neither admitted nor denied wrongdoing. In 1986, the firm was fined $65,000 by the Tennessee Securities Div. for charging excessive markups on trades and for registration violations. In 1989, Iowa also accused GSC of selling securities without registering. The company finally registered in 1990.
GSC's current and former executives have also run into trouble, some of it fatal. Osborne, who ended a consulting relationship with GSC in 1988, was found murdered in his car in a Houston shopping mall in 1990. His death, which police believe was a mob hit, came shortly after he had been arrested while trying to sell an undercover FBI agent $17 million in stolen securities.
While at now-defunct Bevill, Bresler & Shulman Asset Management in 1979, Winter was censured and fined $1,000 by the National Association of Securities Dealers, which accused him of buying bonds for the Utah Central Credit Union without its consent and failing to state on a securities-industry application that he had been convicted on a hot-check charge several years earlier. In 1981, Winter was suspended by the SEC for 20 days after consenting, without admitting or denying allegations against him, that he violated antifraud provisions in connection with alleged unauthorized transactions with a customer. GSC declined to make Winter available for an interview.
No one challenges Winter's prowess as a salesman. In the early 1980s, he gained a foothold in Ohio while hawking Small Business Administration loan investments to Kline, Swartzlander, and other county treasurers. Those investments apparently performed well. The silver-haired, bespectacled Winter did such a good job that by the time Kline retired, Winter had a lock on most of Portage County's investment portfolio. While the county had some money in a state-run fund, Klein "basically used GSC when it had anything to do with investment instruments," says Maureen Frederick, who took over as Portage County treasurer on Sept. 6. "That's not how we're doing it now," she said.
Winter made other valuable contacts in the state largely by schmoozing at county treasurers' association meetings. Tom Steenrod, Athens County treasurer and president of the County Treasurers of Ohio, says Winter is "a smooth talker, a good dresser--a slick son of a bitch."
He also drummed up business by persuading some treasurers to write or sign letters of recommendation to solicit other business. One letter signed by Swartzlander erroneously said the mortgage-backed securities investments he had made through GSC were "backed by the full faith and credit of the United States government." GSC Executive Vice-President Frank J. Klaus says Swartzlander wrote the letter without GSC's knowledge and that the error was brought to Swartzlander's attention. But he says GSC didn't ask for the information to be corrected or for Swartzlander to stop sending out the letter. "By then, we assumed he had already mailed them out," says Klaus. Swartzlander denies he had sent out the letter on his own in the first place and declined to comment further for this story. But officials at two other counties say they got the letter in a packet from GSC.
Winter and GSC may also have lulled Swartzlander and other treasurers with such niceties as all-expense-paid junkets to Houston to visit Government Securities' sleek headquarters and attend pro football games in the firm's luxury sky box at the Astrodome, as reported in the Cleveland Plain Dealer. "We encourage clients and prospective clients to come down and see our operation," LaPorte says. "Sometimes, it's not in their budget, so we have no problem paying....They should know who they're doing business with."
GET SMART. GSC has its defenders. Unlike the fiscal officers in Ohio who are crying foul, a bank finance officer in Somerset, Ky., refuses to blame GSC for the 50% decline in value of a $500,000 IO he purchased from the company in December, 1991. The officer says that about a year ago, GSC recommended he sell the bond or be prepared to hold on to it for quite a while until interest rates rebounded. "But I decided to keep it. I can't blame GSC" for its losses now, he says.
As some financial officers in Ohio see it, GSC and the other firms shouldn't bear all the blame. They contend that state auditors should have had some inkling of the types of investments the local governments were holding. "We feel that's a cop-out," responds a spokesman for the state auditor, who notes that responsibility for investments lies with the local governments. Further, it's not clear, at least in Ohio counties, whether investing in IOs is legal. One thing, though, is clear: As investing grows more sophisticated, so must those who play the game.
LESS THAN A STELLAR PEDIGREE 1979 Government Securities Corp. of Texas founded by Christopher L. LaPorte, John Mark Lee Osborne, and Rick E. Pierson. Founders previously worked at Hibbard, O'Connor & Weeks, a now-defunct securities firm. In 1976 and 1979, the Securities & Exchange Commission charged the firm and certain principals, including Osborne, with violations of antifraud statutes and imposed sanctions upon them. 1985 Suspended by Texas Securities Board for five days for selling securities while failing to register as a dealer. 1986 Fined $65,000 by Tennessee Securities Div. for charging excessive markups on trades and for registration violations. 1989 Accused by Iowa of failing to register. Subsequently complied. 1993 Under investigation by Ohio securities regulators. Suits fly between two Ohio counties and GSC.